Felix Salmon

This is one of the driest pieces of prose you’ve ever seen: a 64-page report from the Government Accountability Office on the subject of the SEC, entitled “Greater Attention Needed to Enhance Communication and Utilization of Resources in the Division of Enforcement”. The “Results in Brief” spreads over six pages and is full of stuff like this:

While Enforcement had demonstrated success in carrying out its law enforcement mission, significant limitations in the division’s management processes and information systems hampered its ability to operate at maximum effectiveness and to use limited resources efficiently, and may have contributed to delays in Fair Fund distributions.

In other words, you’d have to be bonkers to try to read the whole thing.

All hail, then, the mighty Moe Tkacik, who has not only read the report but has distilled from it a picture of such utter dysfunction and managerial incompetence that her blog entry should be required reading for anybody who thinks that the SEC can conceivably be turned into an effective regulatory institution.

What’s entirely clear from Moe’s report is that you’d have to be a masochist of the highest order to work at the SEC. Since we don’t really want our capital markets run by masochists of the highest order, there’s a massive problem here. And I don’t think that there’s any feasible solution.

Ben Bernanke, Tim Geithner, and Sheila Bair have put out a statement which says that the stress tests aren’t just about capital:

Over the next 30 days, any BHC needing to augment its capital buffer will develop a detailed capital plan to be approved by its primary supervisor, in consultation with the FDIC, and will have six months to implement that plan…

In addition, as part of the 30-day planning process, firms will need to review their existing management and Board in order to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment and maintain balance sheet capacity sufficient to continue prudent lending to meet the credit needs of the economy.

I’d love to know what this means. Who’s going to review the management and boards of these companies, if not the management and boards themselves? And what are the chances that any such entity will come to the conclusion that the leadership of the firm does not have “sufficient expertise and ability to manage the risks presented by the current economic environment”?

I suspect that this requirement is basically a way to allow Treasury to make any changes it wants at the top of the banks’ org charts. Obviously Ken and Vikram are at the top of most pundits’ hit lists, but there’s a good chance that Treasury has overly-complaisant boards in its sights too. I’m sure that Walter Massey is a first-rate physicist, but he has no financial experience whatsoever: is he really the best possible person to be chairman of the largest bank in America? I suspect that Treasury might have its doubts.

I was on The World Today this morning, talking about vulture funds:

The bill they’re talking about is this one, which is very similar to the Stop Vulture Funds Act being pushed by Maxine Waters in the US. Essentially it says that if you lend money to a country you have the right to get your money back — but if you then sell that loan to someone else after it has gone into default, the person you sold it to does not have the right to be repaid in full, and instead can only be awarded the amount they originally paid for the debt, plus a small set interest rate.

In other words, the single greatest innovation in the history of debt capital markets — the idea that obligations can be traded, rather than just being held to maturity or litigated upon default — is destroyed at a stroke.

What’s more, the problem these bills are trying to solve is absolutely minuscule. Not only are vulture funds settling their debts for three cents on the dollar, but they more generally have had a very hard time indeed successfully collecting on court judgments around the world. That’s why litigation is a last resort for vultures: anybody who thinks that they buy up this debt with the intention of litigating for repayment in full simply doesn’t understand the business model.

The good news, however, is that neither the UK nor the US bill has any chance of making it into law: the governments in both countries, for all that they’re nominally left-wing, would never support either piece of legislation. This is basically theatre on the part of lawmakers, not a serious and thought-through attempt to rewrite the international financial architecture. If it were, maybe the lawmakers in question might have asked developing countries what they thought of this legislation. And they might well have been surprised at the answer, which is that countries want no part of any act which might hinder their access to capital or their equal-player status on the world stage.

Anti-vulture-fund legislation like this is paternalism of the worst kind: it might be well intentioned, but at heart it’s a bunch of ill-informed northerners telling impoverished southerners what’s good for them. If and when vulture funds ever become a real problem — which I doubt will ever happen — then I fully expect to see the afflicted countries coming up with their own suggested solutions. In the meantime, let’s not exacerbate the plight of those countries by cutting off whatever access to international capital that they currently enjoy.

Update: Sandrew has a very good comment.

When the government announced stress tests on February 23, Bank of America stock closed at $3.91 a share. At that level, if the government converted $34 billion of preferred stock into common equity, it would have received 8.7 billion shares in Bank of America. There are 6.4 billion shares outstanding right now, which means the government would have ended up with a controlling 58% stake in the company.

Today, BAC is trading at $14.64 per share. At that level, the conversion of $34 billion of preferred stock would mean the creation of 2.3 billion new shares, which would give the government ownership of “only” 27% of the company — a large stake, but very much a minority stake. What luck, for all concerned, that the stress-test result, at the current share price, doesn’t risk giving the government control of the bank!

A common meme among CDS pundits is that since credit default swaps behave in some ways like insurance policies, they should be regulated as insurance policies, and no one should be allowed to buy credit protection unless they have an insurable interest in the credit in question — that is, unless they loaned money to it.

Nemo, however, turns that meme on its head, and has decided that if you do have an insurable interest, and then act to collect on your insurance, then you’re “a criminal enterprise”:

Morgan Stanley bought insurance against BTA’s default and then caused that default. If you are wondering how this could possibly be legal, then good.

When he says that Morgan Stanley “caused” a default, he just means that the bank called in its loan, as is its right. But because Morgan Stanley was prudent and bought insurance against the default, its losses won’t be as big as they otherwise would have been. In what way is this supposed to be even unethical, let alone criminal?

Tim Geithner, in his NYT op-ed today:

Some banks will be able to begin returning capital to the government, provided they demonstrate that they can finance themselves without F.D.I.C. guarantees. In fact, we expect banks to repay more than the $25 billion initially estimated. This will free up resources to help support community banks, encourage small-business lending and help repair and restart the securities markets.

On its face, this seems to imply that if and when the big banks start to repay their TARP funds, the TARP will be extended to institutions such as community banks which the government would like to support with TARP money but for whom there’s no money presently in the kitty. That makes sense: while TARP is indeed intended to get banks lending again, it was first and foremost a tool for minimizing systemic risk of the kind simply not posed by community banks and the like.

Incidentally, the $25 billion number is Treasury’s own “conservative estimate“, from back in March, of how much TARP money would be repaid. I guess that estimate has now been increased, although not to any specific number. With all the financial details which are going to be released at 5pm this afternoon, maybe we can forgive Treasury a little bit of fudge on the TARP-repayment front.

The End of Car Culture: Nate Silver on the surprisingly large drop in miles driven in the US.

Stress Test Flunkie Bank Of America Up 36% This Week: Yet another case of rewarding failure.

Rattled in Ridgewood: The plight of the former overclass.

This chart comes from a blog entry by Ann Rutledge, which eventually formed some of the basis for a big National Journal cover story by Corine Hegland. It’s not easy to understand, but essentially the action is in the top right hand corner, which I’ve annotated for the sake of comprehension.

The x-axis, along the top, essentially shows the degree of subordination of a tranche of an asset-backed bond. At the far right is 99%, which means that the lowest tranche accounts for just 1% of the total face value; at the far left is 78%, which means that the lowest tranche is much thicker, accounting for 22% of face value. The y-axis, down the left hand side, is the amount of loss that a bond investor experiences, in basis points. And each line represents the proportion of the pool which goes into default.

What we see in the chart is something pretty interesting. Expected default rates on these structures were always pretty low, in single digits, and at those levels no one ever takes any losses; the holders of the junior tranches make the most money, because they’re getting the highest coupons.

Eventually, when default rates rise, losses rise — and generally, the thinner the tranche, the higher the losses. That’s why the lines generally point down and to the right. (Ignore the horizontal lines along the bottom, for these purposes.) Intuitively, most people looking at the securitization market think that when you have a highly subordinated (highly leveraged) tranche, then it can get wiped out quite quickly once default rates start rising.

But in fact it doesn’t always work that way, and that’s where the convexity comes in. Check out the light-brown line corresponding to a 31% default rate: at the far right hand side of the graph, it actually goes up and to the right. If the lowest (equity) tranche had just 2% of the face value, then it would lose nothing, while if it had 7% of face value, it would lose quite a lot. The reason is that the extra leverage gooses the yield on the tranche so much that the extra income more than makes up for the default losses. As Rutledge puts it in a presentation she gave to the Japan Society:


That 
is 
where 
the 
benefit 
of 
the
 Market 
Spread
 pushes 
deals 
towards 
AAA: 
if 
the 
default
 rate
 is 
within 
the 
original
 range 
of
 expectation 
(that 
is,
the 
“expected
 unexpected 
loss”).



When you have a thin, high-yield tranche, then, you actually benefit from increased leverage at pretty high default rates. Until, suddenly, it falls apart.

Look what happens when the default rate ticks up from 31% to 32% or 33% or 34%: suddenly the advantage of leverage massively backfires, and losses start skyrocketing. Those kind of default rates were never built in to the models being used to rate and value these tranches, though, and ignorance was bliss: the demand for these securities only ever rose, because people ignored the tail risk on the other side of that 31% barrier.

Because the models said the bonds were so safe — look how well they perform even at a 31% default rate! — they themselves became popular instruments to securitize, in the form of CDO-squareds* and the like. Lots of yield, no risk — what’s not to love? Of course, the problem was the tail risk — and because CDO-squareds were made up only of highly-leveraged tranches, even the most senior tranches ended up going to zero when those default rates ticked over the magic line into the murky world of extreme tail risk.

More generally, however, it just takes one glance at this chart to see that all manner of weird stuff is going on there — that there are artifacts of the securitization process which were not at all intended. Writes Rutledge:

The sensitivity of value to default risk and structure, credit convexity, is an intermediate to advanced level problem in fixed income mathematics that, as far as we know, is not taught in any academic finance program other than ours…

Usually when my students (who typically have five to ten years of deal experience) make these diagrams, they gasp in astonishment at the clarity and stark simplicity of what they have never seen before.

What’s quite clear is that the people buying these tranches — often banks playing the regulatory-arbitrage game — generally had no idea what they were letting themselves in for. They knew that they were getting a high yield, and they knew that the Basel rules allowed them to allocate relatively low levels of capital against these securities. Which was fine, because the securities in question (often triple-A tranches of CDO-squareds) had high credit ratings, bestowed by ratings agencies wielding models they didn’t really understand.

And then it all blew up.

*Update: Or even just CDOs. As Corine Hegland emailed to me:

What the heck is the difference between a CDO and a CDO-squared? Does the financial world understand that when it uses pieces of structured securities to build a CDO, instead of using old-fashioned corporate bonds, that it’s basically building a CDO-squared to begin with?

Neither SIFMA, nor other industry materials, nor the rating agencies maintain this distinction, which makes me think that it gets lost, but it’s important. With mortgages, for example, the first securitization technically created residential mortgage-backed securities, or RMBS, which functionally behave like CDOs; the mezz tranches of the RMBS then went into CDOs, which functionally behaved like CDOs-squared. (and the mezz tranches of THOSE CDOs then went into CDOs-squared, creating CDOs-quadrupled? or just tripled?)

The Stanford International Bank Ponzi scheme could and should have been shut down as early as 2003: regulators had more than enough information to do so. Fox Business Network has the story, after receiving 237 pages of SEC documents related to Stanford dating back as far as 2002. This one, I think, is the real smoking gun. It’s worth reading in full — it’s not long — but here are a few snippets:

This letter discloses another possible case of Corporate Fraud being perpetuated by the Stanford Financial Group and its owner, banking and real estate mogul Mr. Allen Stanford.

Stanford Financial is the subject of a lingering corporate fraud scandal perpetuated as a massive Ponzi scheme that will destroy the life savings of many, damage the reputation of all associated parties, ridicule securities and banking authorities, and shame the United States of America…

With the mask of a regulated US corporation and by association with Wall Street giant Bear Stearns, investors are led to believe these CDs are absolutely safe investments. Notwithstanding this promise, investor proceeds are being directed into speculative investments like stocks, options, futures, currencies, real estate and unsecured loans…

The questionable activities of the bank have been covered up by an apparent clean operation of a US broker-dealer affiliate… Registered representatives of the firm, as well as many unregistered representatives that office within the B-D [broker-dealer], are unreasonably pressured into selling the CDs. Solicitation of these high risk offshore securities occurs from the United States and investors are misled about the true nature of the securities.

The offshore bank has never been audited by a large reputable accounting firm, and Stanford has never shown verifiable portfolio appraisals…

By the size of the portfolio, this would be one of the largest Ponzi schemes ever discovered.

This letter is being written by an insider who does not wish to remain silent, but also fears for his own personal safety and that of his family.

It’s all pretty unambiguous stuff, and it was received by the SEC in September 2003 — more than five years before Alex Dalmady published his own, similar, analysis. What’s more, the letter was copied to the Wall Street Journal, the Miami Herald, and the Washington Post; none of them seem to have done anything with it.

If Stanford had been shut down in 2003, billions of dollars would have been saved. But no one seemed to care — certainly not enough to do anything about it. Which is quite disgraceful.

On October 10, 2006, Bloomberg ran a long and important story about how insider trading was endemic in the CDS market. Now, 31 months later, the SEC has finally brought its first insider-trading case involving CDS, and it’s a rather small and unimpressive case at that. What’s more, the SEC still doesn’t seem to have nailed down jurisdiction in these issues.

I know that regulatory agencies move slowly, but this only serves to underline the fact that the SEC should emphatically not be the main regulatory agency charged with overseeing the functioning of the financial markets.

Update: The WSJ got there even earlier than Bloomberg, in August 2006.

The NYT finally gets one of the stress-test anonymice on the record today, in the person of Steele Alphin, BofA’s chief administrative officer, and what he said is flabbergasting:

Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own…

Mr. Alphin said since the government figure is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government.

For one thing, you can’t just repay the $11 billion if you don’t think you need it any more: before any TARP funds are repaid, any bank needs to have weaned itself off the FDIC’s bank-debt guarantee program, among other conditions.

But more to the point, the minimum amount of tangible common equity that a bank requires under the stress-test is not the same thing as the maximum amount of capital, including preferred stock, that a bank reasonably needs to have. The stress-test capital requirements are in addition to regulatory capital requirements, not a replacement for them. And since the government’s preferred stock does count towards a bank’s regulatory capital, then you can’t just repay it on the grounds that it doesn’t count in the stress-test calculations.

It seems to me that BofA is in some weird state of denial here, where a $35 billion capital shortfall can be considered evidence that it actually has more regulatory capital than it really needs. What’s more, the bank now seems to be happy going on the record with this kind of analysis. Which doesn’t instill in me a great deal of confidence in its management.

So much for anchoring. You thought BofA might need $10 billion in new capital? Try $35 billion. Or, in English, lots and lots and lots of money — much more money than the bank could conceivably raise privately.

The first obvious question is “if BofA needs $35 billion, how much does Citi need?”. Which leads straight into the question of how much the other 19 banks need, in aggregate — it’s likely to be a shockingly enormous sum.

The second obvious question is “when will Ken Lewis and Vikram Pandit resign?” — I can’t imagine either of them surviving a forced capital injection of this magnitude.

And the third obvious question is “what on earth does Treasury think it’s doing”, leaking the stress tests in such a ham-fisted way, with each iteration worse than the last.

I don’t blame the banks for being angry. They have hundreds of people making sure that they’re well capitalized; Treasury then sends in a handful of wonks to look over the books and a few weeks later determines that they’re off by $35 billion? That’s quite a shortfall, especially when there’s really no indication that Treasury is better at working these things out than the bankers are.

I fear that in the wake of these stress tests, Treasury will have created an atmosphere of antagonism and mistrust which is going to make it almost impossible to push through the kind of root-and-branch regulatory reform that’s desperately needed. Without the banks’ buy-in, no new regulatory structure is going to work — but right now the banks have every incentive to hide things from Treasury and the regulators, rather than to work with them to strengthen the system as a whole. The stress tests might end up improving the banks’ TCE ratios — but that doesn’t mean they will end up improving the health of the financial system as a whole.

Update: There’s been a bit of confusion about what I was trying to say here, so let me clarify: Treasury might well be — and probably is — entirely correct about the amount of capital the banks need. But from the banks’ point of view, that’s not true: they think that Treasury is being too harsh. Which will make them unwilling to cooperate and will create an antagonistic playing field.

Jonathan F (a/k/a my boss) wonders whether Goldman’s decision to ignore credit ratings when it comes to bond-investment mandates might not be counterproductive:

The problem with using market prices as a signal for any market action is that it tends to encourage herding by making any market movement self reinforcing. So if a company’s spread widened (or its stock price fell) then investors would react, say by selling its paper, which would then presumably lead to a further credit downgrade. There was a credit agency (it belonged to one of the big ones) that adopted this approach and was blamed for some of the death spirals (or near death spirals) in bank equities in the autumn of 2002 (Commerzbank, etc).

What he’s talking about is a move from the current system, where investors sell bonds which are downgraded to junk, to a new system where investors sell bonds with high credit spreads. Given the choice, the second one seems fairer to me — it means that companies aren’t at the mercy of credit-rating agencies, especially near the crucial triple-B cusp, and it also makes it much easier for the ratings agencies to make that now-fateful downgrade into the Cs.

Taking a bigger-picture view, it can reasonably be said that the ratings agencies, to a good approximation, are basically just lagging indicators for the credit markets anyway. So if you’re going to be exiting certain credits, better you do it sooner, when they gap out, rather than later, when they’re finally downgraded.

It’s also only a minority of corporate credits which really get actively damaged by wider spreads in any case: essentially, it’s the levered companies with a lot of short-term debt needing to be rolled over in the near future. That includes all banks, of course, as well as quasi-banks like GE — but most corporates fund themselves with a mixture of long-term bonds and bank lines of credit, which aren’t nearly as susceptible to market whims.

A move to judging credits based on their spreads rather than their ratings might also help put an end to ratings arbitrage, where companies try to issue debt not where it makes the most sense, necessarily, but rather where they can do so at the lowest cost without damaging their ratings. Essentially the ratings agencies become not a dispassionate observer of how creditworthy the issuer is, so much as a key constituency to be kept in mind when putting any kind of debt deal together. That’s unhealthy, as we saw in the wake of the structured-credit boom. And it should come to an end in the corporate world, too.

But mostly fund managers should stop relying on ratings in any case. They’re both in the business of judging credit: fund managers who outsource that business to a ratings agency are simply not doing their job. And their clients shouldn’t ask that they do so.

The behavioral sociology of measuring energy usage is simple: the more you know about how much energy you’re using, the less you use. Just getting the information cuts most people’s energy usage by somewhere between 5% and 15%, while people with high electricity bills (like me) find it much easier to isolate exactly what is causing those bills and can then work out how best to reduce them through upgrading appliances or replacing incandescent bulbs with CFLs or any number of other routes to energy efficiency.

The problem is in the measurement. There is a natty gadget known as the Wattson which measures home energy use, but it’s expensive, and almost impossible to find outside the UK, for some reason.

Enter Google, which has now announced plans to release free PowerMeter software which will map any individual’s energy use on their phone, home computer, or iGoogle homepage. The little gizmo which plugs in to your fusebox is going to be very cheap, and with any luck will somehow be available for free to anybody who might have difficulty paying for it. (This is part of Google’s philanthropic google.org arm, after all.)

Google’s Dan Reicher mentioned the PowerMeter on a panel at the New Yorker Summit today, and I can’t wait to get one — I anticipate it’ll save me a few hundred dollars a year. His colleagues have already installed it — one of them discovered he was paying for all the washers and dryers in his building. When will I be able to get mine?

I had a short chat with Nassim Taleb this morning about his new paper with Charles Tapiero, entitled “Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions”.

There’s a great deal of mathematics in the paper, which is full of equations and greek letters, but the gist of it is explained in pretty plain English:

Societe Generale lost close to $7 Billions dollars, around $6 Billions of which came mostly from the liquidations costs of the (hidden) positions of Jerome Kerviel, a rogue trader, in amounts around $65 Billions (mostly in equity indices). The liquidation caused the collapse of world markets by close to 12%. The losses of $7 Billion did not arise from the risks but from the loss aversion and the fact that costs rise disproportionately to the size of the bank…

Consider the following two idealized situations.

Situation 1: there are 10 banks with a possible rogue trader hiding 6.5 billions, and probability p for such an event for every bank over one year. The liquidation costs for $6.5 billion are negligible. There are expected to be 10 p such events but with total costs of no major consequence.

Situation 2: One large bank 10 times the size, similar to the more efficient Société Génerale, with the same probability p, a larger hidden position of $65 billion. It is expected that there will be p such events, but with $6.5 losses per event. Total expected losses are p $6.5 per time unit – lumpier but deeper and with a worse expectation.

In other words, small mistakes we can live with. Large mistakes we can’t, because when a mistake the size of Kerviel’s is unwound, the costs are enormous — not only to SocGen, which lost upwards of $6 billion, but also to all shareholders globally, who saw the value of their holdings marked down by trillions of dollars thanks to the effects of SocGen’s enormous and chaotic forced unwind.

The lessons here are broader, and apply to the practice of M&A more generally: when industries consolidate, there might well be economies of scale — but at the same time tail risks increase. What happens when a massive amount of technology outsourcing is consolidated in Bangalore, or computer-chip manufacture is consolidated in Taiwan? Efficiency rises — but so does the risk that one disastrous event could have massive systemic consequences.

The solution for banks is relatively simple: just put a cap on their size. (I’ve been suggesting $300 billion.) What’s the solution for other industries, which also naturally tend to consolidate and cluster? I’m not sure, but in an increasingly interconnected and just-in-time world, the risks are greater than ever.

Update: A couple of good comments from dsquared; the first points out that the paper ignores problems of correlation, which is true. But as Rick Bookstaber is more than happy to point out (and Taleb is no fan of Bookstaber), correlations tend to pop up in the most unlikely places, and in general they just make everything more dangerous — not only the systemic risk of lots of small players failing at once, but also the systemic risk associated with one large failure. So add in correlations to Taleb’s model and I think it only becomes scarier.

Dsquared then asks whether we really want to move to a world of “Fewer SocGens, More Barings”. My memories of the systemic implications of the Barings collapse are hazy (maybe John Gapper or even Nick Denton can help out here), but I think the answer might well be yes: while the Barings collapse was bad for Barings, it didn’t have the kind of negative externalities that we saw with Kerviel. But I might be wrong on that front.